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Paper F9

Financial Management

December 2016

Answer Guide

Health Warning!

BEFORE looking at these suggested answers.

Then constructively compare your answer,

identifying the points you made well and

identifying those not so well made.

If you got the basics wrong: re-revise by re-

writing them out until you get them correct.

How to fail Simply read or audit the answers congratulating

yourself that you would have answered the

questions as per the suggested answers.

Interactive World Wide Ltd, September 2016

All rights reserved. No part of this publication may be reproduced, stored in a retrieval

system, or transmitted, in any form or by any means, electronic, mechanical,

photocopying, recording or otherwise, without the prior written permission of Interactive

World Wide Ltd.

Section A

1. A

The amount received is: $500,000/$15570 = 321,130

2. A

3. B

Using CAPM, the expected return for the equity shareholders is: 3% + [08 (9% 3%)]

= 78%

The predicted market value of a share is:

P0 = D1/K0

= 40p

------

0078

= 5128 pence

4. C

5. C

Year Cash inflow Discount rate 8% Present value

1 10 093 930

2 110 086 9460

10390

6. C

7. C

80 = X + 12 (7 X)

X = 20

Y = 20 + 18 (70 20)

Y = 110

8. B

9. C

Project Investment Present value of Profitability Ranking

outlay net cash inflows index

$m $m

J 40 48 12 3

B 45 64 14 1

T 60 66 11 4

N 70 92 13 2

10. D

Under the weak form, new information is not anticipated and share prices change over

time in a random manner.

11. C

$000

$050 Ordinary shares 5,000

Share premium 1,400

Retained profits 5,000

11,400

Earnings per share = 1,140/10,000 = 114 cents

12. D

Answer D is correct. Retained earnings are not a free source of finance as investors will

expect a return in line with that required by the equity shares of the company. Invoice

discounting does not involve the administration of debtors; it is simply a form of finance.

A bank overdraft is repayable on demand.

13. D

Year 0 1 2 3

Gamma

Cash flows (200) 120 60 80

Discount rate (10%) 10 0909 0826 0751

(200) 10908 4956 6008

NPV 18.72

Year 0 1 2 3

Cash flows (200) 20 60 80

Discount rate (16%) 10 0862 0743 0641

(200) 10344 4458 5128

NPV = (0.7)

So IRR is approximately = 16% as IRR is the rate that makes the NPV zero

14. A

$

Original share (4 x $1000) 4000

Rights share (1 x $1000 x 080) 8.00

5 shares 48.00

TERP = 48/5 = $9.6

Value per original share = 10 9.6 = $0.4

15. B

cost

Ordinary shares 040 15 60

Loan capital 060 9 54

11.4%

Section B

16. B

Total Value = Noncurrent assets + current assets current liabilities long term

debt preference share capital

$602m + $750m - $305m - $180m - $105m = $762m

Total Shares = $200m / $0.50 = 400m

Per Share = $762m / 400m = $1.91

17. C

18. C

$216m x 8 = $1728m

Total Shares = $200m / $0.50 = 400m

Per Share = $1728m / 400m = $4.32

19. D

20. A

21. A

$

Annual purchases (8,000 x $60) 480,000

Annual ordering costs [(8,000/100) x $50] 4,000

Annual holding costs [(100/2) x $80] 4,000

488,000

22. D

$

Annual purchases [8,000 x ($60 x 96%)] 460,800

Annual ordering costs [(8,000/400) x $50] 1,000

Annual holding costs [(400/2) x $80] 16,000

477,800

23. C

$

Annual purchases [8,000 x ($60 x 25%)] 12,000

24. B

25. B

26. D

Company 1 154m

Company 2 89m

Company 3 75m

million payment.

27. A

28. D

29. C

The company will deposit $ today earning interest in USA at 4.2% per annum.

The required $s will be obtained at the spot rate

These will be borrowed at a cost of 5.4% per annum (2.7% for six months)

30. B

The borrowing rates would be used and pro rata for the six months

Question 31

flows (discounted using the appropriate cost of capital) less the initial

investment.

The $2,500,000 research cost is sunk as it has already been incurred and

as such is irrelevant to cash flow. It should be ignored.

Selling price, variable cost and fixed costs are all in current prices and

should be adjusted by their respective inflation rates from year one

onwards.

balance basis.

total recovered in year four.

Marking scheme

NPV

Sales 1

Variable cost 1

Fixed costs 1

Tax on operating profit 2

Tax saved on capital allowances 3

Residual value 1

Working capital 1

Net present value 1

Comment on the acceptability of the project 1

Max 10 marks

Advantages of IRR 2

Advantages of IRR 2

Max 4 marks

Post-tax cost of debt 11

Maintenance 1

Tax Saved 1

PV Purchase 1

PV Lease 1

Comment

1

Max 6 marks

Years 0 1 2 3 4 5

$000 $000 $000 $000 $000 $000

Sales 42,000 169,820 231,500 36,460

Variable cost (18,720) (75,740) (143,375) (23,860)

Fixed costs (10,500) (11,025) (11,576) (12,155)

12,780 83,055 76,549 445

Tax 30% (3,834) (24,917) (22,965) (134)

Tax savings on capital allows 9,000 6,750 5,063 12,188

Equipment cost (120,000)

Resale value 10,000

Working capital (20,000) (600) (618) (637) 21,855

Net cash flows (140,000) 12,180 87,603 57,745 14,398 12,054

DF (11%) 1 0.901 0.812 0.731 0.659 0.593

Present values (140,000) 10,974 71,134 42,212 9,488 7,148

Since the net present value is positive the project is financially acceptable.

Workings

Sales

Years 1 2 3 4

$000 $000 $000 $000

Inflation 1.05 1

1.05 2

1.05 3

1.054

Inflated selling price 2,100 2,426 1,852 1,823

Units (000) 20 70 125 20

Sales ($000) 42,000 169,820 231,500 36,460

Variable cost

Years 1 2 3 4

$000 $000 $000 $000

Variable cost per unit 900 1,000 1,020 1,020

Inflation 1.04 1

1.04 2

1.04 3

1.044

936 1,082 1,147 1,193

Units (000) 20 70 125 20

Total variable cost ($000) 18,720 75,740 143,375 23,860

Fixed costs

Years 1 2 3 4

$000 $000 $000 $000

Inflation 1.051 1.052 1.053 1.054

Inflated fixed cost 10,500 11,025 11,576 12,155

$000

2 0.75 x 9000 6750

3 0.75 x 6750 5063

4 Difference 12,187

(120,000 - 10,000) x 30% 33,000

Working capital

Years 0 1 2 3 4

$000 $000 $000 $000

Total working capital (1.03) 20,000 20,600 21,218 21,855

Increase in working capital 20,000 600 618 637 21,855

cash flows

Advantages:

Like the NPV method, IRR recognises the time value of money.

It is based on cash flows, not accounting profits which can easily be manipulated.

investment

For accept/ reject decisions on individual projects, the IRR method will reach the

same decision as the NPV method

Disadvantages:

Does not indicate the size of the investment, thus the risk involve in the investment.

Assumes that earnings throughout the period of the investment are re-invested at

the same rate of return.

If a project has irregular cash flows there are more than one IRR for that project

(multiple IRRs).

(c)

The discount factor is the post tax cost of debt thus 7.14% x (1 - 0.30) =5%

Years 0 1 2 3 4 5

$000 $000 $000 $000 $000 $000

Maintenance (3,000) (3,000) (3,000) (3,000)

Tax Saved 900 900 900 900

Tax saved Cap All 9,000 6,750 5,063 12,188

Equipment cost (120,000)

Resale Value 10,000

Net cash flows (120,000) (3,000) 6,900 4,650 12,963 13,088

DF (5%) 1 0.952 0.907 0.864 0.823 0.784

Present values (120,000) (2,856) 6,258 4,018 10,669 10,261

Present value

($91,650)

Years 0 1 2 3 4 5

$000 $000 $000 $000 $000 $000

Maintenance (35,000) (35,000) (35,000) (35,000)

Tax Saved 10,500 10,500 10,500 10,500

Net cash flows (35,000) (35,000) (24,500) (24,500) 10,500 10,500

DF (5%) 1 0.952 0.907 0.864 0.823 0.784

Present values (35,000) (33,320) (22,222) (21,168) 8,642 8,232

Present value

($94,836)

Question 32

Calculate the cost of equity using the capital assets pricing model. This

requires the use of the risk free rate, equity beta and the average

market return.

Calculate the cost of equity using the dividend valuation model. This

requires the use of dividend, market price and dividend growth rate.

mainly due to the different assumptions made by each method.

Calculate the cost of debt as the internal rate of return as the debt is a

redeemable traded debt.

Calculate the cost of the bank loan as the net interest on the bank loan.

Calculate the market values of equity, bank loan and the redeemable

debt.

Calculate the WACC as the weighted average of the cost of equity, bank

loan and the redeemable debt using their respective market values for

the weighting.

Marking scheme

Marks

(a)

Cost of equity using CAPM 2

Cost of equity using DVM

Dividend growth rate 1

Market price if equity 1

Cost of equity 1

Comment 3

Max 8

(b)

Cost of bank loan 1

Cost of loan notes:

Net interest 1

First NPV

Second NPV

Internal rate of return = cost of debt 1

Market values of equity

Market value loan notes

WACC 1

Max 6

(c)

Explanation of systematic risk 2

Explanation of unsystematic risk 2

Main difference 2

Max 6

Cost of equity = [($018 x 1052 / $495) + 0052] x 100% = 903%

The answers are different because of the assumptions made in calculating them. The DVM

method is an implicit method in that it assumes that the future growth rate of dividends

and the share price are accurate. The CAPM method is an explicit method, in that it

assesses the cost of equity based on the systematic risk of the investment, which is given

by the beta. The systematic risk cannot be diversified away and reflects the business and

financial risk of the company.

Cost of bank loan = 7% x (1 025) = 525%

0 (103) 1 (103) 1 (103)

15 6 412 2527 4329 2597

5 100 0747 747 0784 784

(303) 137

Market value of equity = $495 x 200,000,000 shares = $990,000,000

Market value of loan notes = 103/100 x $150,000,000 = $154,500,000

Market value of bank loan = $120,000,000

Total market value = $1,264,500,000

Systematic risk or market risk is the risk that cannot be reduced or eliminated as a result

of a well-diversified portfolio.

The systematic risk is measured by the beta factor and thus measures the sensitivity of a

security to changes in the returns on the market as whole. It simply measures the

relationship between the market return and the individual security return.

Unsystematic risk or unique risk is a risk which can be reduced or eliminated as a result

of a well-diversified portfolio. Unsystematic risk relates to individual or specific companies

rather than to the financial system as a whole.

CAPM distinguishes between systematic and unsystematic risk and indicates that unique

risk can be cancelled out by diversification, thus, in a well-balanced portfolio an investors

gains and losses from the unique risk of individual shares will tend to cancel each other

out. The distinction between these two risks can be shown as follow

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